Portfolio Protection Step 5: Put Options

Options can help you protect profits or just stop the bleeding

In my recent article 5 Steps to Protect Your Portfolio, the final step I discussed was utilizing put options as insurance that any unrealized gains you have don’t turn into losses.

Most investors have heard of options but often think they are just for rich folks or hedge-fund managers, who employ them for speculative purposes. Certainly, sophisticated investors regularly use them as leverage to maximize their portfolio gains. But they also like to use options such as puts to nail down their gains and to mitigate losses should their stocks’ prices head in the wrong direction.

In essence, put options provide protection by betting that the underlying stock will decline. They give you the right (not the obligation) to sell the stock at a certain price at a specific future time.

There are three scenarios in which a put can help you protect your portfolio:

Protect Unrealized Profits

Let’s pretend you own 100 shares of Intel (NASDAQ:INTC), which closed yesterday at $26.71. The stock has had a nice run this year, up from its 52-week low of $19.16. If you had bought those shares at the low, you would be sitting on a gain of about 39% today — not too shabby for a very volatile market!

And while you might think the shares have more momentum in the short term (like I do), so you don’t want to sell them right now, you also know any whiff of trouble from Europe or other bad economic news could send the market — and Intel’s fortunes — downhill.

That’s when buying a protective put can help mitigate your potential loss.

First, you buy one put option from your broker, which gives you the right to sell 100 shares of INTC.

If you are very risk-averse and decide you want to protect your current gain, you can buy a put option that allows you to sell INTC at a price of $26 through July 20, 2012. (Note: There are many options available, depending on your time frame. Read more about Intel’s options here.)

As of Jan. 24, this particular put will cost you about $202, plus commission. If the price of INTC continues climbing, you will be out the $202 you paid for the option, but you will reap the benefit of the price increase in your INTC shares. But if the price of INTC stock declines under $26, you can still sell it at that price, through July 20. Bottom line: You have locked in your gain!

Protect your New Stock Purchases

Let’s use the same scenario. But say you just purchase 100 shares of INTC for the first time today and you want to protect your money. You do the same thing — buy a put option with a July 20, 2012, expiration with a strike price of 26 (your purchase price). Again, the cost will be $202. If the stock goes below $26, you still can sell it at that price. And if it rises, you don’t have to do anything; just enjoy your gains!

Protect Current Holdings That Have Declined in Value From Further Downside

Now let’s say you bought 100 shares of a stock that has fallen in value, from $30 to $25 per share — a loss of $500), and you are willing to hang in if it falls another couple of dollars, to $23 per share, but you don’t really want to lose any more than that. You can buy a put option — let’s estimate that cost at $200 — that will allow you to sell your shares at $23 (your strike price), even if they fall below that level. Although you are already in the red by $700 at this point, the put limits further downside loss. And if the shares go up, you can sell your put to recoup all or part of that cost, retaining your actual shares. And, of course, if your shares rise enough, you might cash out with a gain!

You see, buying puts is not that complicated at all!

And there’s more good news! You don’t have to limit your protection to just individual stocks; you can also employ index puts to protect your entire portfolio. And of course, there are lots of choices, corresponding to the broad indices, as well as sector indices. They work essentially the same way — protecting your portfolio against broad market or sector declines.

Using puts to protect your portfolio can be money well spent, and can be economical, in the long run. Investors are beginning to realize they also are not as complex as they originally thought, and have begun ramping up their use. Discount broker ETrade (NASDAQ:ETFC) recently reported that 20% of its trading volume is now in options. And at brokerage firms whose customers are primarily traders, that volume can reach more than 40% of their trades.

While there are plenty of very complex options, most investors will do well by simply using put options for portfolio protection. And in volatile markets like those we currently are experiencing, it might be well worth your while — and your money.